The recession question

Worries about a looming economic downturn persist—what’s an investor to do?

Concerns of recession continue

One of the biggest questions for investors over the past several months has been whether our economy is headed for a recession. With the Fed increasing interest rates to slow economic activity and ease inflation, many have feared the economy might be headed for a downturn. And shockwaves sent by recent bank failures have prompted further worry about our future. Stock market investors are understandably concerned.

It’s important to note that the stock market is not the economy, but they are related. Stock prices tend to rise when the outlook for our economy is bright and fall when it darkens. The unpredictable nature of the business cycle is a systemic risk to assets with high volatility, such as stocks, which is why investors are so concerned about the overall health of the economy.

The Waterwheel has written plenty about recession concerns as of late. We continue to remind readers that predicting economic growth and contraction is notoriously difficult, and no one does it on a consistent basis with any measure of success.

Take, for instance, a Bloomberg survey asking leading economists to estimate economic growth over the last quarter (prior to the announcement of the actual figures to be released later this month). A collection of 59 responses showed a median projection of a 1.3% seasonally adjusted annual growth rate for Q1 2023 GDP. The most optimistic prediction was 3.3%, while the most pessimistic was -0.4%, indicating a significant range of expectations. The fact remains that there can only be one correct value, which implies that most of these forecasts will ultimately be off the mark.

Recessions as investment risk

The pursuit of returns through investment in capital markets always involves risks, systemic or otherwise. We all know that the future never quite unfolds in the exact way anyone expects. We can, however, work to identify challenges that might disrupt our desired outcomes.

But as we see in the Bloomberg survey growth estimates, even professional forecasters don’t reliably know the exact probabilities of adverse events. In a similar survey, the median response from economists forecasting the chance of a recession within the next year was 65%. The high estimate was 98% and the low was 1%. You don’t need to be a data scientist to recognize the vastness of this spectrum.

Even if a forecaster was somehow able to accurately predict a recession, it would be even more difficult to know exactly how capital markets would respond to such a downturn. All recessions are different, and the stock market’s response varies with each recession. Predicting the nature and timing of that response is even harder than predicting the recession itself.

The stock market tends to be forward looking and responds unfavorably in the short-term when expectations for an economic downturn emerge. The price level of the S&P 500 Index has fallen 12% from its peak in December 2021, at least in part due to ongoing expectations of a recession that has yet to come. If a recession does materialize, will stock prices respond by falling even further or will expectations for a recovery send stock prices higher? That likely depends on whether the recession is more severe or more moderate than what markets are currently anticipating.

This isn’t to say that investors should ignore recession risk. On the contrary, a clear understanding of risks such as recessions is essential in developing a clear-headed investment plan that provides exposure to the benefits of capital markets while also providing protection from negative outcomes.

Recession risk management

Risk management starts with the development of a proactive investment plan that reflects an investor’s goals and appetite for risk. A long-term investor seeking to benefit from capital markets should expect to see economic downturns from time to time—there have been six official recessions since 1980.

An appropriate plan should account for the reality of recession risk and typically does so by diversifying holdings and allocating assets between a mix of stock and bonds, which tend to perform differently in varying economic conditions.

As an example, a portfolio invested 60% in U.S. stocks and 40% in U.S. bonds would have produced an average annual rate of return of 10.6% between 1980 and 2022. Yet investors holding that portfolio would have seen negative returns in 7 of the 42 years, with average intra-year drops of -7.7%. If investors intermittently bought and sold during these times based on estimates that even professional forecasters struggle to get right, there’s no telling what the effects would have been. But a 60/40 investor that stuck to their plan would have reaped that 10.6% annual return, despite the six recessions that occurred.

The Alesco Advisors investment team understands that predicting the exact nature and timing of recessions is a complex and uncertain endeavor. Instead of trying to time the market with temporary adjustments based on unreliable forecasts, we look beyond short-term noise to develop proactive, strategic, diversified asset allocation plans tailored to each investor’s long-term financial objectives.

Regardless of forecasts about a looming recession, committing to an investment plan that accounts for the reality of risks over time is the best way for investors to weather economic storms. Those who stick to such plans during challenging times are often rewarded for their steadfastness.